Forward contracts trade in the over-the-counter market. They do not trade on an exchange such as the NYSE, NYMEX, CME, or CBOE.
When a forward contract expires, the transaction is settled in one of two ways. The first way is through a process known as “delivery.”
Under this type of settlement, the party that is long the forward contract position will pay the party that is short the position when the asset is delivered, and the transaction is finalized.
While the transactional concept of “delivery” is simple to understand, the implementation of delivering the underlying asset may be very difficult for the party holding the short position.
As a result, a forward contract can also be completed through a process known as “cash settlement.”
A cash settlement is more complex than a delivery settlement, but it is still relatively straightforward to understand.
For example, at the beginning of the year, a cereal company agrees through a forward I contract to buy 1 million bushels of com at $5 per bushel from a farmer on Nov. 30 of the same year.
At the end of November, suppose that corn is selling for $4 per bushel on the open market. In this example, the cereal company, which is long the forward contract position, is due to receive from the farmer an asset that is now worth $4 per bushel.
However, since it was agreed at the beginning of the year that the cereal company would pay $5 per bushel, the cereal company could simply request that the farmer sell the com in the open market at $4 per bushel, and the cereal company would make a cash payment of $1 per bushel to the farmer.
Under this proposal, the farmer would still receive $5 per bushel of com. In terms of the other side of the transaction, the cereal company would then simply purchase the necessary bushels of com in the open market at $4 per bushel.
The net effect of this process would be a $1 payment per bushel of com from the cereal company to the farmer. In this case, a cash settlement was used for the sole purpose of simplifying the delivery process.